RELEVANT COSTING

DECISION MAKING – is the process of choosing from at least two alternatives. For business
entities, management must choose in favor of the option that maximizes the company profit.

SHORT-TERM DECISION ALTERNATIVES

1. Make or buy a part or a product line
2. Accept or reject a special order
3. Sell or process further a product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors

TYPICAL DECISION MAKING PROCESS

1. Defining the problem.
2. Specifying the objective and criteria.
3. Identifying the alternative courses of action.
4. Evaluating the possible consequences of the alternatives.
5. Collecting the data needed to make decision.
6. Choosing the best alternative and making the decision.
7. Evaluating the results of the decision.

FACTORS CONSIDERED IN DECISION MAKING

 Qualitative Factors – factors that cannot be expressed effectively in numerical terms.
 Quantitative Factors – factors that can be expressed in monetary or other numerical
units.
Quantitative approaches in decision making:
1. TOTAL Approach – the total revenues and costs are determined for each alternative,
and the results are compared to serve as a basis for the decision to make.
2. DIFFERENTIAL Approach – only the differences or changes in costs and revenues
are considered.
NOTE: In decision-making cases that involve a conflict between qualitative and
quantitative factors, quality usually prevails over quantity.

TERMINOLOGIES USED IN SHORT-TERM DECISION MAKING

RELEVANT COSTS Future costs that are different among alternatives; it is considered
as the avoidable costs of a particular decision.

DIFFERENTIAL COSTS Increases (increments) or decreases (decrements) in total costs

that result from selecting one alternative instead of another.
[Relevant]

AVOIDABLE COSTS Costs that will be saved or those that will not be incurred if a
certain decision is made. [Relevant]

OPPORTUNITY COSTS Income sacrificed or benefit foregone when a certain alternative is

chosen over another alternative. [Relevant]

SUNK COSTS Costs that are incurred already and cannot be avoided regardless
of what decision is made. [Irrelevant]

SHUTDOWN COSTS Usual costs that a company will continue even if it decides to
discontinue or shutdown the operation of a company segment.
[Irrelevant]

JOINT COSTS Costs incurred in simultaneously manufacturing two or more

(joint) products that are difficult to identify individually as
separate types of products until the products reach a certain
processing stage known as the split-off point. [Irrelevant]

FURTHER PROCESSING Costs incurred beyond the split-off point as separated joint
 COSTS products are to be processed further. [Relevant]

SPLIT OFF POINT The earliest stage in the production where joint products can be
recognized as distinct and separate products.

BOTTLENECK Any particular resource or operation where the capacity is less

RESOURCES than the demand placed upon it.

SHORT-TERM DECISION MAKING GUIDELINES

Basic rule: Choose the action that will yield the BEST PROFIT POSITION.

Highest Revenues
Highest possible profit
Lowest Costs

NATURE OF ALTERNATIVES DESCRIPTION DECISION GUIDELINES

1. MAKE or BUY a part / Should a part or product be Choose the option that has the
product manufactured (in-sourced) or lower cost. In most cases, fixed
bought (outsourced) from costs are irrelevant. Consider
outside supplier? opportunity costs, if any.
2. ACCEPT or REJECT a Should a special order that Accept the order when the
special order requires a price lower than the additional revenue from the
regular selling price be special order exceeds
accepted? additional cost, provided the
regular market will not be
affected. In most cases, fixed
costs are irrelevant.
3. CONTINUE or SHUTDOWN Should a business segment, Continue if segment’s
a business segment which may be a product line, a avoidable revenue is greater
department or a branch, be than its avoidable costs;
continued or discontinued? otherwise, consider shutting
down the segment. Since
allocated fixed cost is usually
unavoidable, it is considered
irrelevant.
4. SELL or PROCESS Should a product, after Process further if additional
FURTHER a product undergoing the joint process, be revenue from processing
sold at the split-off point or be further is greater than further
processed further? processing costs. Joint costs,
since already incurred prior to
the split-off point, are
considered sunk costs and
irrelevant.
5. BEST PRODUCT Which product(s) should be Identify and measure the
COMBINATION (Optimization produced and sold when there constraint on the limited
of Scarce Resources) is a given limited resources or resource(s). Rank the
bottleneck operation? product(s) according to the
highest contribution margin per
unit of limited resources.
6. CHANGE IN PROFIT Should any of the profit factors Identify the factor to change
FACTORS such as selling price, unit sales, and the amount of
variable cost, fixed cost and contemplated change. Change
sales mix be manipulated to the profit factor if it will cause
increase profit? an improvement on the
company’s over-all profit
position.
 EXERCISES
1. TOTAL ANALYSIS vs. DIFFERENTIAL ANALYSIS
London Company has a single product called Heathrow. The company currently sells 8,000 units of
Heathrow at P40 per unit. The company’s costs at this level of activity are given below:
Variable Costs:
Direct materials P10
Direct labor 8
Variable overhead 5
Variable selling expense 2
P25

Fixed Costs:
Fixed overhead P50,000
Fixed selling expense 20,000

REQUIRED:
1. What is London Company’s profit?
2. London Company could increase its sales by 25% if it spends P20,000 for
advertisements.
Determine the effect on company profit using:
A) Total Analysis
B) Differential Analysis

2. MAKE OR BUY (OUTSOURCING DECISION)

BMW Motors must decide whether it must continue to produce an engine component or but it from
Sarao-Philippines for P2,500 each. The demand for the coming year is 20 units. The costs of
producing a single unit of the engine component are as follows:
Direct materials P1,300
Direct labor 700
Factory overhead (80% fixed) 1,000
P3,000
If BMW buys the components, the facility now used to make the components can be rented out to
another firm for P4,000.

REQUIRED:
Should BMW make or buy the components?

3. ACCEPT OR REJECT (SPECIAL ORDER DECISION)

Antonia Company sells a product for a regular unit price of P75.00. The cost of producing and
selling a unit of this product at the normal activity level of 50,000 units per month is as follows:
Manufacturing costs:
Direct materials P32.50 per unit
Direct labor 7.50 per unit
Variable manufacturing overhead 3.00 per unit
Fixed manufacturing overhead P100,000 per month
Selling and administrative costs:
Variable P2.50 per unit
Fixed P36,000 per month
An order has been received from a customer for 5,000 units at a discounted unit price of P50.00.
This order has no effect on normal sales and would not change the amount of total fixed costs. The
variable selling & administrative expense would be P0.50 less per unit on this order than on normal
sales.

REQUIRED:
Should Antonia accept or reject the special order?

4. SPECIAL ORDER PRICING

Conrada Company sells I-Phone 10 at a price of P28,000 per unit. The costs per unit are:
Direct materials P8,000
Direct labor 6,000
Variable overhead 4,000
Fixed overhead 2,000
TOTAL P20,000
A special order for 1,000 units was received from Marcia Bona, a well-known cell phone dealer
based in Cavite. Additional shipping costs for this sale are P2,000 per unit.

REQUIRED:
What is the minimum selling price per unit for the special order if:
A) Conrada is operating at FULL capacity?
B) Conrada has EXCESS capacity?

5. SHUTTING DOWN OPERATIONS

The most recent monthly income statements for Fermina Stores is given below:
Cebu Branch Davao Branch Total
Sales P1,200,000 P800,000 P2,000,000
Less: Variable expenses (840,000) (360,000) (1,200,000)
Contribution margin P360,000 P440,000 P800,000
Less: Traceable fixed expenses (210,000) (180,000) (390,000)
Segment margin P150,000 P260,000 P410,000
Less: Common fixed expenses (180,000) (120,000) (300,000)
Profit (loss) (P30,000) P140,000 P110,000
If Cebu Branch were eliminated, then its traceable fixed expenses could be avoided. The total
common fixed expenses are merely allocated and would be unaffected.
A) What will be the new company profit (loss) if Cebu Branch is eliminated?
a. P 260,000 c. (P 40,000)
b. P 140,000 d. (P 70,000)
B) What will be the decrease in company profit if Cebu Branch is closed and 20% of its traceable
fixed expense would remain unchanged while Davao sales would decrease by 20%?
a. P 352,000 c. P 136,000
b. P 280,000 d. No decrease; profit will increase

6. PRODUCT ELIMINATION POINT

Chrissy Company expects that sales will drop below the current level of 5,000 units per month. An
income statement prepared for the monthly sales of 5,000 units show the following:
Sales (5,000 @ P3) P15,000
Less:
Variable costs (5,000 @ P2) P10,000
Fixed costs 5,000 15,000
Profit -Nil-
If plant operations are suspended, a shutdown costs (i.e., plant maintenance and taxes) of P2,000
per month will remain as incurred. Since there is no immediate possibility of profit under present
conditions, the problem of the company is just how to minimize the loss.

REQUIRED:
1. What is the shutdown point in units?
2. Should the company continue or shut down operations if sales next month are
expected to be:
A) 4,000 units?
B) 2,000 units?

7. SELL OR PROCESS FURTHER

Gorgonia Company produces four products for a joint cost of P10,000. The firm could sell the
products at the split-off point for the following amounts:
M P15,000
I 10,000
L 2,000
O 0
At present, the products are processed beyond the split-off point and they are sold as follows:
Products Sales Additional Processing Cost
M P40,000 P28,000
I 30,000 16,000
L 20,000 14,000
O 2,500 3,000

REQUIRED:
1. Which product(s) should the firm sell at split-off point?
 2. If the company takes the most profitable action, then what will be its profit?

8. BEST PRODUCT COMBINATION

Kulang Co. produces three products: A, B and C. One machine is used to produce the products.
The contribution margins, sales demands, and time on the machine (in hours) are as follows:
Market Limit Unit Contribution Margin Hours on Machine
A 100 units P20 10 per unit
B 80 units P18 5 per unit
C 150 units P25 10 per unit
There are 2,400 hours available on the machine during the week. Total fixed cost is P5,000.

REQUIRED:
1. What is the best product combination that maximizes the weekly contribution?
a. 10 units of A; 80 units of B; 150 units of C
b. 50 units of A; 80 units of B; 150 units of C
c. 90 units of A; 0 unit B; 150 units of C
d. 100 units of A; 80 units of B; 100 units of C
2. How much is the profit associated with the best product combination?